Can Sovereign Wealth Funds Learn to Zig When Markets Zag?

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One advantage of sovereign wealth funds is their
multi-generational investment horizons, which should enable
them to adopt a countercyclical stance in their investments:
buy low, sell high. But Sovereign Wealth Center data shows they
are more likely to follow the pack.

On a sunny day in Rome last week, Norway’s central
bank Governor Øystein Olsen addressed the Italian
Banking, Insurance and Finance Federation (FeBAF). The subject:
the $890 billion Government Pension Fund Global (GPFG). He
told the trade group audience that the fund’s
long-term horizon puts it "in a position to be a
countercyclical investor on a systematic basis." Norges Bank
Investment Management (NBIM), which runs the fund, did so
by frequently "rebalancing the share of the portfolio allocated
to equities."

Such rebalancing — which requires the the sale of
appreciated securities and the purchase of lagging ones
— is inherently countercyclical and even contrarian.
The practice has proven profitable, said Olsen, increasing
returns by about 0.5 percentage points annualized since NBIM
initiated the strategy in 2001.

NBIM has a strict rebalancing rule, ensuring the
fund’s stock allocation remains between 56 percent
and 64 percent. Other sovereign investors seem to be less
disciplined in tacking against the prevalent market direction.
Taking such contrarian-like positions often results in
short-term losses, especially during times of market volatility
and sovereign wealth funds need to have the backing and trust
of various stakeholders — governments, parliaments or
emirs — to execute such a strategy. Support can be
difficult to come by.

But by avoiding short-term losses, sovereign wealth funds
are not maximizing their ability to make long-term returns,
according to experts. "Asset allocation rebalancing is widely
used by liability-driven investors, and smart individuals,"
wrote Michel Meert, Director of Investment Advisory for
professional services firm PwC in an opinion piece for
Sovereign Wealth Center last week. Sovereign wealth funds,
however, have generally been slow to employ the practice in a
disciplined fashion. "It is not given sufficient emphasis,"
Meert wrote.

"Patient Investors"

Sovereign Wealth Center’s transaction database
(which excludes NBIM’s open-market stock trades
that are part of its indexed strategies) backs Meert up.
Sovereign wealth funds could be far better at investing
countercyclically. An analysis of our investment data from 2005
to the first quarter of 2015 shows that there is a strong
correlation between upward swings in the market cycle and
sovereign funds’ increased willingness to take on
risk — and vice versa.

This trend suggests that although these funds are supposed
to invest for the long term and theoretically be indifferent to
cyclical market movements. Instead, they tend to follow trends
like other investors — piling in as markets rise and
selling when they tumble. That’s a surefire recipe
for underperformance.

The 2008–’09 financial crisis was a
case in point. When the chips were down, sovereign wealth funds
drew back from the market: Their annual investment abroad fell
by nearly half, to $44.8 billion in 2009 from $86.9 billion in
2008, even as they continued to pump cash into the financial
services sector. Foreign investment declined further in 2010,
to $37.7 billion. As a consultant in 2009, I pointed out that
the retreat from the markets was ill-advised and was
particularly surprising to see among the more experienced of
these funds. "It would be short—sighted to forego opportunities
to invest when they have available cash," I wrote at the time.
"Moreover, for the first time in years, the current environment
offers abundant opportunities for patient investors."

But pull back they did. Even relatively experienced
investors like Singapore’s $315 billion GIC chose
to sit on its hands. In 2007 GIC made $7.4 billion of direct
investments abroad, in 2009 and 2010 the fund invested less
than half that amount annually according to Sovereign Wealth
Center data. While some of this drop may be accounted for by
plummeting asset prices, the number of deals
Singapore’s sovereign fund closed also dropped by
nearly half, to 24 in 2009 from 42 two years earlier.

Rising Prices

To be sure, the trauma of the financial crisis was extreme
and it might be asking too much of sovereign wealth funds, or
any individual or institution to invest at the bottom of that
cataclysmic market bust — although firms from
Appaloosa Management to Berkshire Hathaway certainly did.

But in 2013, macroeconomic conditions were certainly less
dire — though debate over the U.S. tapering of
quantitative easing was raising investor concerns. State-owned
investors’ investment abroad plunged to near-2010
levels: just$39.3 billion.

For NBIM, which is only permitted to invest in publicly
listed securities outside of real estate, investing against the
ebb and flow of stock markets does not entail inordinate risks,
particularly given its almost unlimited investment horizon. But
for those sovereign wealth funds that do invest in unlisted
companies and other non—traded assets, the financial crisis
provided a chance to act as purveyors of liquidity, providing
equity or even debt funding to cash starved companies. They
didn’t.

The chart below suggests that between 2008 and 2010
sovereign wealth funds favored buying publicly listed
securities to unlisted assets as their appetite for risk
plummeted with investor sentiment. Liquidity risk, or the
likelihood that an asset may not be easily tradeable, is a
concern for investors with liabilities to fund, but should not
be for most sovereign wealth funds that are supposedly free
from such obligations.

After 2010, sovereign wealth funds took advantage of the
opportunities in infrastructure, private equity and real
estate. From 2011 — the height of the euro zone debt
crisis — sovereign funds were able to purchase these
assets at comparatively low valuations. With bond yields low,
state-owned investors are allocating more of their portfolios
to non-tradable assets as a way to generate higher returns.
Prices now are rising sharply, increasing the chances of a
bust.

Silk Road Fund

Most sovereign wealth funds invest to meet their risk-return
mandates. We’re now a long way from the days of
2006 and 2007 when sovereign wealth funds were shrouded in
mystery, largely thanks to the formation of the International Forum of Sovereign
Wealth Funds and its members’ adoption of the
Generally Accepted Principles and Practices (the so-called
Santiago Principles), which guide their governance and
investment behavior. The markets are now largely satisfied that
these state-owned investors are not bent on manipulating the
markets for economic or political purposes. But while this is
true abroad, it is less the case in many of their home
markets.

The wisdom of sovereign wealth funds investing in their
domestic markets is a hot topic (see here and here) — too large to be tackled
here — but it is obvious from Sovereign Wealth Center
data that while on the whole sovereign wealth funds without an
explicit domestic mandate tend to stay off their home turf, in
extremis they do just that.

The chart below shows a spike in domestic spending in 2009,
when it rose to $42.5 billion — almost half of their
total expenditure — up from $23.9 billion the previous
year, and just $5.3 billion in 2007. During the crisis,
governments called on their sovereign wealth funds to rescue
their economies, primarily supporting struggling local banks
and real estate developers, as well as helping fund new
infrastructure projects. Such largesse helped assuage local
discontent with funds experiencing vast paper losses in Western
bank bailouts and helped replace foreign capital, which fled
Middle Eastern countries during the worst of the
recession.

Sovereign Wealth Fund Foreign and Domestic Investments
2005–’15

Source: Sovereign Wealth Center

Sovereign wealth fund investment in domestic markets crept
up again in 2014 as oil prices tumbled in the second half of
the year and the Chinese economy slowed to lowest levels of
growth since the financial crisis. The People’s
Republic of China’s sovereign wealth funds
allocated a total of $8 billion to the State
Council’s new Silk Road Fund, which was launched
in December to finance an ambitious plan to expand
infrastructure, resource development, industrial and financial
cooperation with China across the Eastern hemisphere.

Chasing Bubbles?

Lastly. sovereign wealth funds have a habit of fueling asset
price increases to unsustainable levels. Over the past year,
Sovereign Wealth Center has identified three potential bubbles
into which state—owned investors have poured cash.

Consumer Technology: The level of dealmaking in the consumer technology sector —
particularly in the U.S. and Asia — is flirting with
dotcom-era levels and sovereign wealth funds have been in the
thick of it. Whether it is the Qatar Investment Authority, with an
estimated $304 billion in assets under management, backing
car-hailing app Uber Technologies at a $45 billion
valuation, GIC supporting India’s rival to
Amazon.com, Flipkart, twice in 2014, at a valuation of $7
billion in July and $11 billion in December, or
Singapore’s $177 billion Temasek Holdings pouring
money into Chinese firms like car-hailing app Didi Dache or
online restaurant review service Dianping.com, sovereign wealth
funds now see consumer technology as a growing sector in which
they want to play.

But with technology companies seeking to avoid a replay of
the 2000 dotcom bubble and shunning public listings, whether
these investments will prove to have been unwisely overpriced
won’t be known for years. Some funds have already
made a killing. The Abu Dhabi Investment Council invested in
messaging service WhatsApp in 2013. Whatever the valuation
then, you can be sure that the Council reaped a mighty return
on its investment when Facebook bought the company for $22
billion in October 2014.

Healthcare and Biotechnology: In 2014 health care and
biotechnology stocks soared in the U.S. Buoyed by new drug
developments, an aging population and industry-wide
consolidation, the S&P 500 health care index advanced 24
percent in 2014. Sovereign wealth funds have, again, been
prominent players. Temasek has been particularly active, buying
stakes in Gilead Sciences, the $51.1 billion Alaska Permanent
Fund Corp.–backed cancer treatment start-up Juno
Therapeutics and Thermo Fisher Scientific. Even the Kuwait
Investment Authority (KIA), got in on the game with a rare
direct investment in NantHealth, a cloud-based healthcare
information technology company.

Real Estate and Infrastructure: Sovereign wealth
funds’ appetite for property and established
infrastructure assets seems insatiable. But they are now facing
growing competition for prime assets. This has either
encouraged them to search for better yields in other types of
properties — such as industrial, retail and logistics
— or forced them to increase their offers. In
particular NBIM announced last year that it will attempt to
invest 1 percent of its $890 billion fund into core real estate
in developed markets each year from 2014 to 2016. Last year it
managed to deploy $5.4 billion. With yields now heading toward
record lows, even NBIM is having to look outside gateway cities
in Europe and the U.S. for reasonable returns.

Scary Place

Despite protestations to the contrary, sovereign wealth
funds struggle to take advantage of one of their greatest
endowments — their intergenerational investment
horizon — by investing against the direction of the
market. Paying greater attention to portfolio rebalancing might
seem like a simple solution, but in truth it’s
more complicated.

Achieving consensus among stakeholders for pursuing such a
strategy is challenging in a political context. Governments,
and particularly parliamentarians, hate to see even short-term
or unrealized losses on a sovereign wealth fund’s
balance sheet at the end of the year. Consequently they often
seek to minimize losses at times of market volatility rather
than using the opportunity to seek out longer-term gains. They
want to avoid being taken to task for short-term red ink, as
the $548 billion KIA is only too aware of as a result of its
now annual public beratings in parliament.

One sovereign wealth fund that has actively sought to
address this challenge by gaining the support and trust of its
government owner is the $21.5 billion New Zealand
Superannuation Fund. Matt Whineray, the fund’s
CIO, told Sovereign Wealth Center last month that the difficult
part of the fund’s strategic tilting strategy,
which enables it to take short-term contrarian positions, is
"to create the discipline to put the positions on
notwithstanding volatility." To do so, the fund structured the
strategy so that it makes such moves reflexively, rather than
after deliberation. "Our default is to put something on and
only in exceptional circumstances depart from the model, which
really aids the countercyclicality of the strategy," Whineray
says.

But such exemplars are scarce. Whineray concedes those
contrarian bets are "a scary place to be" even for investment
professionals. The challenge that all sovereign wealth funds
face is to make their stakeholders less afraid of the
short-term losses and incentivize their staff to take the
long-term outlook. Both are easier said than done.

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